Question

Book Name: Principles of Managerial Finance - 180 Day Option, 14th Edition
Lawrence J. Gitman

P1–2 Accrual income versus cash flow for a period  Thomas Book Sales, Inc., supplies textbooks to college and university bookstores. The books are shipped with a proviso that they must be paid for within 30 days but can be returned for a full refund credit within 90 days. In 2014, Thomas shipped and billed book titles totaling $760,000. Collections, net of return credits, during the year totaled $690,000. The company spent $300,000 acquiring the books that it shipped.

1. Using accrual accounting and the preceding values, show the firm’s net profit for the past year.
2. Using cash accounting and the preceding values, show the firm’s net cash flow for the past year.
3. Which of these statements is more useful to the financial manager? Why? (please provide me with a detailed calculation for my reference, thank you!)

Answer 1

a. Under accrual basis of accounting, revenues and expenses are recorded in the accounting period in which they are earned or incurred, irrespective of whether such revenues have been received or expenses have been paid.

Accrual basis is mainly adopted for financial accounting and reporting purposes.

For example, if we made a sale of $100 on credit basis to a person X in period 0 and only 50% of the money i.e $50 has been received in period 0; then we will record the full sale amount($100) in period 0 even though we did not receive full the payment in period 0.

Net Income/(Loss) => Total Revenue - Total Expense

As per accrual basis of accounting Total revenue is the total amount with respect to shipped and billed book titles i.e $760,000.

Total expense is the amount spent towards acquiring the books= $300,000

Net profit for 2014 = $760,000 - $300,000 => $460,000

b. Under cash basis of accounting, revenues and expenses are recorded in the accounting period in which they have been received or paid.

Cash accounting is mainly adopted for financial management to determine the cash flows from investments.

For example, if we made a sale of $100 on credit basis to a person X in period 0 and only 50% of the money i.e $50 has been received in period 0; then we will record the amount of sale proceeds received in period 0 i.e $50.

Net cash flow => Cash inflow - Cash outflow

As per cash basis of accounting, cash inflow is the total amount of collections, net of return credits received with respect to sale of books i.e $690,000. Cash outflow is the total amount spent towards acquisition of books.

Net cash flow for 2014 => $690,000 - $300,000 => $390,000

c. Cash flow statement is more useful to the financial manager due to the reason that a financial manager is dependent on the financial analysis of cash-flows to achieve the desired return from investments made by the owners of the equity.